Bear Mountain Capital Inc.

The 10 most likely contributors to the next market panic

| June 15, 2010


I think this is a very insightful (and not overdone) article about investor psychology and what could trigger the next market panic.  Most of the items listed here I agree with, except maybe for the technical “death cross”, which is primarily due to that fact that I don’t subscribe to technical analysis.

I’ve pasted the article from, an industry news source, and its guest columnist Rob Isbitts (June 15, 2010):

“The stock market climbs a wall of worry.” That classic Wall Street adage describes the significant human emotion that drives investor behavior. Even in good markets, investors tend to find things to worry about. It may be as simple as thinking that because things are going so well, they can only get worse. The particulars have been different at each point in market history, but the swings in collective investment psyche have been even more dramatic in recent years.

Starting in October 2007, a 55%+ decline in the S&P 500 Stock Index in 18 months was followed by an 80%+ gain over 13 months. Now we find ourselves in the midst of another decline and the accompanying high volatility. The question we must consider now is whether this “correction” (Wall Street’s way of avoiding the word “loss”) is simply the breeding ground for the next global market panic, or will this most recent climb up the wall of worry end with the walls crumbling down?!

The answer depends on what events create the emotional landscape from here. So, it seems appropriate at this point to outline the most likely contributors to the next market panic…before the fact, not after.

1. Panic sellers swamp buyers. Yes, one reason the market may panic is panic itself. FDR had it right when he famously said that the only thing we have to fear is fear itself. I have observed over time that many market declines occur in phases. In phase one, the bad news is well-known but the market ignores it. In phase two, something triggers the recognition that this bad news is actually a reason to sell. That is how my team and I view May’s decline. Phase three, if it occurs, could very well bring us little significant new reasons to sell…other than that people are selling. It’s a sort of self-fulfilling prophesy, but it happens time and time again. Markets overshoot reality on the upside and on the downside, and any steward of client capital today should not only recognize that, but be prepared to handle it in their portfolio management approach. I see many that recognize it, but not enough that do anything about it.

2. The “second shoe” drops on housing market. Economist/fund manager Dr. John Hussman recently wrote that “…the main struggle of the stock market here is not about Europe, but rather centers on the likelihood that the U.S. will experience a second wave of credit strains. Clearly, the level of credit strains will be a function of mortgage delinquencies and foreclosure losses, both realized and anticipated. I’ve noted that we entered the primary window for these strains to emerge only a few months ago. Alt-A and Option-ARM mortgage resets will hit their stride between (June) and November, with a second, even higher peak in 2011, before finally trailing off in early 2012. I am most concerned about the “recognition phase” in which the current, very low estimates of credit strains are revised by investors.” That is, not only is there the risk of another housing crisis, but there is a risk that the risk will be underestimated! This combines my first two items here.

3. A leveraged ETF “blowup” kills confidence – my team and I have avoided using leveraged ETFs. We believe they are strictly for short-term traders, given the math of how their prices adjust to fluctuations in market prices of the index they are tracking. The problem is that short-term traders are not the only ones who use them. The dollar trading volume in levered ETFs is many, many times that of the single long or short ETF that tracks the same index. This is an accident waiting to happen. I can’t say I agree with Cramer on much (I imagine vice-versa if he ever heard my views), but we do agree on this: these things should be outlawed or have great restrictions on their use.

4. Derivatives-induced waves of selling, as large investment firms seek to cover their mistakes. I could describe this, but history is littered with so many incidents of this, I suspect it requires no additional explanation. Still, how soon we forget the risk here…

5. A prominent Wall Street firm or money manager loses a massive amount of assets due to “wrong-way bets” or derivatives exposure that was underestimated by the market. This occurred in many past panics, and there is no reason it couldn’t happen again. I can think of a huge bond firm that could be a risk here. I’m just saying…

6. A technical “death cross” – this is defined by chartists as when a security’s 50-day moving average crosses below the 200-day moving average. Several major stock indices are within striking distance of incurring such a death cross, and the publicity surrounding such an event is enough to cause some panic. To market technicians, this was a key stock market signal during the vicious fourth quarter of 2008. Could it be again? Whether it happens or not, let’s not ignore the fact that it’s in the range of realistic possibility, or as we call it where I live in South Florida, as hurricane season begins, the “cone of uncertainty.”

7. “Buy the dip”-itis. This is the emotional condition that causes investors to relive the glory days of the late 1990s, when every drop in price was a “buying opportunity.” This has become so cliche? in the financial media that it is hard to listen to it without laughing. Its like saying that tomorrow will be a sunny day. There have been many sunny days in the past and there will naturally be more. But not every day greets you with warm sunshine (my apologies to those readers in San Diego, where every morning IS sunny and warm). And, not every dip is a buying opportunity. However, as my portfolio team colleague and Barron’s columnist Michael Kahn has said many times recently, the stock market’s trend changed from up to down in late April. That means that all the dip-buying is meaningless, unless prices reach a level that breaks the downtrend. A 2% up day here or there is not enough to make that happen. Michael also tells me that there are multiple technical cycles that point to a market bottom in the seasonally weak September-October time frame. Combine that with the housing data I referenced earlier, and you have yourself a possibility for some bad karma this summer and into the autumn (or shall I say, “fall”).

8. Increased recognition of what I will call the “SAI process,” where SAI stands for Stimulus, Austerity, Inflation. Taking a big step back, the current market worries stem from the issue of deleveraging. That is, consumers and governments around the world spent too much compared to what they had. They were able to do so because they used borrowed money alongside their “real” money. Once the banking system was nearly brought to its knees during 2007-2008, that game was suddenly over, and it will be over for a long time. It seems to me that the method of long-term recovery from this morass most favored by sovereign governments, starting with Greece and the other PIIGS and continuing onto more prominent economies, is to first stimulate the economy with low interest rates, government spending programs and targeted liquidity moves. When that results in limited progress, the next move is to put the hammer down and start cutting services and pay, and increasing taxes. No one likes that, and I am not opining on the pros/cons of doing it. My job and yours is to observe carefully, evaluate risk-reward and make ongoing decisions on how to preserve and grow people’s hard-earned wealth, with an emphasis on avoiding the “big loss” along the way. So austerity’s low popularity is not our concern, but its impact on society and markets is. This is all part of the painful deleveraging process, and unless the world takes it in stride, the next step is inevitable: to make up for the limited progress brought about by stimulus and austerity, printing money becomes the next, necessary and potentially ugly step. All of this is to say that if the SAI trend continues, more rounds of investor panic will accompany it. Think early 1970s, without Nixon this time.

9. A terrorist plot that succeeds on American soil – something we really don’t want to envision as investors, but after 9/11, we must. Recent reminders of the potential threats in New York and elsewhere, including some by U.S. residents and even military members, are always a shock to the system. Those events of the past year did not rattle the markets, but there could be a simple explanation for that: perhaps the market was in too good a mood to let that bother it. Today, that is not the case. Let’s just all hope that of the 10 items laid out in this article, this one is the least likely to happen.

10. The little guy gets screwed again, and reacts to it. It happens every time. The public watches a huge stock market rally, finally, gives in and buys, and within 2-3 months of entering, the market peaks and crumbles around them. They retrench, declare they will never invest in stocks again, and they are true to their word…until the next huge market rally. Then they pile in once more and the “game” they see investing as happens to them all over again. I am talking about the contrarian indicator known as dollar flows into mutual funds, published by the Investment Company Institute (ICI). It just seems to paint a picture of the “little guy” buying his mutual funds just as things are about to get worse. More than a day late and many dollars short, you might say.

However, this is exactly where you CAN be a hero. The mutual fund is still the vehicle of choice for many RIAs, and this is a time you should be defining for clients and prospects the major difference between just buying funds as a do-it-yourselfer and constructing portfolios allocated using mutual funds as a very convenient and effective way to execute their overall investment strategy. The “little guy” chases performance; the RIA allocates assets. They both use mutual funds, but they use them very differently.

As a Little League baseball coach, I see a lot of young pitchers try to develop a “changeup” to mix in with their fastball, to keep the hitters off-balance. There are those who learn to throw the ball with the same motion but with a different grip, which makes the pitch effective (with a lot of practice). Other kids start their delivery as if they are going to throw hard, then at the last minute slow their arm down. A good coach will point out to the latter kid that he is not throwing a changeup, but he IS progressing toward arm surgery at a young age, because he is not using the proper mechanics. You can be the coach to the investor to make sure they know how to prepare mentally and via portfolio construction when the global markets throw them a “changeup.” Just as avoiding the big loss is the most critical investment skill, and some of the best investment decisions are the ones you don’t make, your awareness of the factors that could drive the next market panic can help you and your clients run through that wall of worry, not into it.